Walk the Line: Classifying Cash Flows under ASC 230 – Issue 3 of 8
Walk the Line: Classifying Cash Flows under ASC 230 – Issue 3 of 8

Walk the Line: Classifying Cash Flows under ASC 230 – Issue 3 of 8

If you are an auditor or if you prepare financial statements, let me start by asking you a few questions. Which financial statement is your primary focus? Which is the last that you focus on? Undoubtedly, the statement of cash flows ends up pretty far down the list and is often the one that receives the least attention from both a preparation and an audit perspective. Yet, it is often the statement that receives the most attention from investors and analysts. It has also received quite a lot of focus in recent years from the SEC, ranking 2nd in frequency of issue occurrence in restatements according to a May 2016 study by Audit Analytics. The SEC has also issued numerous comment letters to companies regarding proper classification of cash flows and cited issues in this area in a number of speeches. Why? ASC 230, Statement of Cash Flows, was issued 30 years ago and hasn’t changed much since. On top of that, there really are only three ways to classify: investing, financing, or operating! Sounds pretty easy, so why all the issues? The reasons are many, but one key reason is that the guidance isn’t always clear, and there is a lot of gray area with certain types of cash flows. As a result, the FASB issued ASU 2016-15 Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments, to address eight areas that weren’t clear, leading to diversity in practice. The classification issues covered in ASU 2016-15 are:

It’s now time to walk the line and properly classify cash flows in the statement of cash flows. Let’s take a look at one of the eight issues recently addressed by the FASB in ASU 2016-15, settlement of zero-coupon bonds. A separate blog is available for each of the other issues and can be accessed by clicking the items in the above list.

The best way to explore this cash flow classification issue is through a scenario followed by a question and answer. But before we get started, let’s review a few things. What is a zero-coupon bond? Unlike other debt instruments, a zero-coupon bond does not provide the holder with periodic interest payments. Where are interest payments classified in the statement of cash flows? Interest payments should be classified as cash outflows from operating activities. Remember that proceeds from issuing bonds and other borrowing activities are cash inflows from financing activities. Repayments of amounts borrowed and principal payments are cash outflows from financing activities. Okay great, but a zero-coupon bond has no interest payments, right? Right. Unlike other debt instruments, zero-coupon bonds do not provide the holder with periodic interest payments. The holders of those instruments are compensated for the use of their funds via a single payment when the bonds are repurchased or redeemed at maturity. Zero-coupon bonds are generally issued at a significant discount from their face value, therefore the interest is in essence paid for at maturity. Okay, now that we’ve covered the background, it’s time for our scenario.

Scenario: Ira Hayes Corp. issued a five-year zero-coupon bond with a face value of $1 million for $750,000 to Dylan, Inc. Ira Hayes will not make any interest payments to Dylan during the five-year period, it will simply repay the $1 million at the end of five years. Over the five-year period, Ira Hayes will amortize the $250,000 difference to interest expense.

Since Ira Hayes is not making any interest payments, the controller plans to show the receipt of the $750,000 in proceeds as a cash inflow from financing activities and the $1 million redemption payment in five years as a cash outflow from financing activities.

Question: Is this presentation in the cash flow statement appropriate?

Answer: No. At settlement, the portion of the cash payment attributable to accreted interest (i.e. the debt discount of $250,000) should be classified as a cash outflow from operating activities and the portion attributable to principal should be classified as a cash outflow for financing activities. ASU 2016-15 provided this clarification because there was diversity in practice with many entities using the methodology described by the controller of Ira Hayes in our scenario. Note that this guidance also applies to other debt instruments with coupon interest rates that are insignificant in relation to the effective interest rate of the borrowing (a “very low-coupon bond” for short).

We’ve now addressed one of the eight cash flow classification issues in ASU 2016-15. Check out the additional blogs in this series for more cash flow classification issues and answers!

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